401(k) tax breaks in lawmakers’ gunsights

Tax reform could change some retirement savers’ plans

SAN FRANCISCO (MarketWatch)—As the fiscal-cliff debate staggers on, some in the retirement industry have come out swinging against the possibility of lawmakers slashing tax benefits for 401(k)s and similar retirement plans. But do 401(k)s need protection? That is, are lawmakers really gunning for the billions of dollars of uncollected tax revenue sitting in retirement plans?

The answer is a qualified maybe.

Some say it’s inevitable lawmakers will at least look at limiting the tax benefits of such plans. After all, tax deferral for 401(k)-type plans will cost the government an estimated $429 billion from 2013 through 2017. (There are many ways to estimate the total amount of lost revenue. The figure above is from the fiscal year 2013 federal budget. See that budget report here.

“The numbers are big enough that I think [lawmakers] will evaluate whether the tax preferences given to these plans are worthwhile,” said Craig Rosenthal, a partner with Mercer, a human-resources consulting firm, in New York.

Few expect Congress to start tinkering with retirement-plan tax breaks between now and the end of the year. That hasn’t stopped the American Society of Pension Professionals and Actuaries, a trade group, from developing a media campaign, complete with website, Facebook page, and Twitter handle, to encourage retirement savers to contact their members of Congress to forestall any such changes.

The industry is worried that revenue-seeking lawmakers may slash the 401(k) maximum contribution amount. Various deficit-trimming proposals in recent years suggest that very idea, not least the Simpson-Bowles plan of 2010, which proposed limiting the total annual contribution from employee and employer combined to the lowest of 20% of salary, or $20,000. The current annual maximum for employer and worker contributions is about $51,000. Read the 2010 Simpson-Bowles report here.

Long-term outlook

Still, it’s unlikely 401(k) changes will get adopted soon. “I do not expect any change as part of the current [fiscal cliff] negotiations,” said Dallas Salisbury, chief executive of the Employee Benefit Research Institute, a nonprofit think tank.

But in 2013 or 2014, “tax expenditures” (that is, the money the government doesn’t collect due to tax breaks) will be on the table, Salisbury said. “Should the parties take the approach that both have discussed—that is, a dollar limit on itemized deductions or a maximum tax rate applied to deductions—then retirement incentives will likely be left where they are, or very close to it,” Salisbury said.

But if broad tax reform is taken off the table, he said, look for lawmakers to raise revenue by trimming the maximum-contribution amount and other means, with an effective date of 2014 at the earliest.

Others agreed. With regard to trimming 401(k) tax breaks, “There’s nothing that the tax-writing committees or anybody who has real influence is really pushing at this stage,” said Eric Toder, co-director of the Tax Policy Center, a joint venture of the Brookings Institution and the Urban Institute.

Even if lawmakers eventually do limit the 401(k) maximum contribution amount, that’s not likely to change savings rates, Toder said. “There are very few people who contribute to the contribution maximum.”

Shifting the tax break

That’s why the Pension Rights Center, a group that advocates for retirement savers, would like to see lawmakers trim the 401(k) tax break—but not for the purpose of reducing the deficit.

“The fact is that people who are at the top of the income ladder would be saving for retirement probably without these tax incentives,” said Karen Friedman, executive vice president of the Pension Rights Center. These tax benefits, she said, should be “reaching those folks who are low and moderate wage earners.”

Expanding the saver’s credit is one lever for doing so, she said. Another idea the PRC likes: a new type of retirement plan where contributions by lower-income workers would be subsidized by the government. “Why not look at how these tax subsidies are being directed and make them more efficient?” she said.

Still, even people who are not at the high end of the income scale may get hit if lawmakers change 401(k) contribution rules, said Mercer’s Rosenthal.

For savers who see retirement fast approaching and are eager to ramp up contributions to get ready for that big day, a reduced maximum contribution could be a problem, he said.

“My fear is that a lot of that reduced savings is going to come out of the near retirees—the people who are within say 10, 15 years of becoming retirement-eligible,” Rosenthal said. “They’re at their prime earning years and they really are catching up from when they weren’t able to save as much earlier in their careers. It would be a real shame if they were unable to do so because of a change in the tax law.”

Another concern, some say, is that a reduction in benefits for higher-earning employees may prompt some employers to stop offering 401(k)s, a prospect that could be bad news for all retirement savers.

But all of these fears may be unfounded, given that lawmakers still appear far apart on fundamental tax issues.

“I’m a little pessimistic that we’ll get any serious effort at tackling tax reform,” said Mark Luscombe, principal tax analyst with CCH Inc., a Riverwoods, Ill.-based tax publisher and unit of Wolters Kluwer.

After all, in 2010, the Simpson-Bowles commission went nowhere fast. Still, “maybe the economic situation is more dire now,” Luscombe said. “As the deficit keeps growing, [lawmakers] might be moved to do things they wouldn’t otherwise have done.”

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